Chapter 15

Contents
3.1 Leverage and Capital structure 3.1.5 Optimal or Ideal Capital
3.1.1 Business and financial risk Structure
3.1.2 Types of leverage 3.1.5.1 Factors affecting
3.1.2.1 Operating leverage capital structure decisions
3.1.2.2 Financial leverage 3.1.5.2 WACC and capital
3.1.2.3 Total leverage structure
3.1.3 The Firms Capital Structure 3.1.5.3 Hamada equation
3.1.4 Capital Structure Theories 3.1.5.4 EBIT-EPS approach
3.1.4.1 Modigliani and Miller 3.1.5.5 Share value
(M&M) maximization
3.1.4.2 Trade-off theory
3.1.4.3 Signaling theory
3.1.4.4 Pecking order hypothesis
3.1.4.5 Windows of opportunity
Business risk
!  Is the riskiness inherent in the firm’s operations (or
riskiness of firm’s assets) if no debt is used
!  Is the risk of being unable to cover operating costs
!  Common measure: standard deviation of σROIC
(Return on invested capital)
!  ROIC = EBIT (1-T)/ Total invested capital

Probability density Low risk

High risk

0 EBIT
Factors affecting business risk

Product
obsolescence
Legal,
Sales and
regulatory
cost
and foreign
variability
risk exposure

Competition
Business Operating
risk Leverage
Financial risk
!  Is the increase in stockholder’s risk, over and
above the firm’s business risk, resulting from
the use of financial leverage
!  Is the risk of being unable to cover financial
costs
!  More debt or preferred stock, more financial
risk
 Analysis and impact of Leverage

!  Leverage results from the use of fixed-cost

assets or fixed cost funds to magnify returns to
the firm’s owners.
!  Generally, increases in leverage result in
increases in risk and return, whereas decreases
in leverage result in decreases in risk and
return.
Operating Leverage
!  Is the extent to which fixed operating costs are
used in the firm’s operations
!  The higher the operating leverage, the higher
the business risk

Rev. Rev.
P P
TC
TC

VC=50 VC=47 FC
FC =7K
=5K
QBE
P80
Sales QBE Sales
=167 =213
Financial Leverage
!  Is the extent to which fixed-income securities are used
in a firm’s capital structure
!  The higher the financial leverage, the higher the
financial risk

P900 profit

10% interest
P9,000 capital

P600 loss
Total Leverage
!  results from the combined effect of using both fixed
operating and fixed financial costs;
!  Hence, DTL = DOL x DFL
 Degree of Operating Degree of Degree of Total
Leverage (DOL) Financial Leverage (DTL)
Leverage (DFL)

Effect Use of Fixed Operating Use of Fixed Use of Fixed costs

Costs to magnify effect Financial Costs (both operating and
of changes in Sales to (interest on debt and financial) to magnify
EBIT PS dividends) effect of changes in
to magnify effect of Sales to EPS
changes in EBIT to
EPS
Formula
(measuring
sensitivity)
=DOL x DFL
Formula
(at base
level)
Tri-Star Productions, Inc. is evaluating two different
operating structures which are described below.
The firm has common shares outstanding of 1,000, and a
tax rate of 30%. Sales price per unit is at P1.

Operating @ 10,000 units sold @ 20,000 units sold

structure
#1 EBIT = P1,500 EBIT = P3,500
EPS= 0.35 EPS= 1.75
#2 EBIT = P1,500 EBIT = P4,500
EPS= 0.875 EPS = 2.975

For each operating structure, calculate DOL, DFL and DTL.

Which operating structure has greater business risk? Financial risk?
Total risk? If Tri-Star Productions, Inc. projects sales of 20,000 units,
which operating structure is recommended?
Cost data of the 2 operating structure of Tri-star
Productions are as follows:

Fixed costs Price VC per Interest

per unit unit exp.
Structure #1 P500 P1 0.80 P1,000
Structure #2 P1,500 P1 0.70 P250

Calculate DOL, DFL and DTL using 20,000 units as a base

sales level with preferred stock dividends as follows:

EBIT PS EPS (with

dividends PS div.)
Structure #1 P3,500 P280 1.47
Structure #2 P4,500 P420 2.555
The Firm’s Capital Structure
•  Capital structure is the mix of debt and equity
used by the firm.
•  Financial structure is the mix of sources of
financing used by the firm to finance its assets

Accounts payable Non-interest

bearing
Accrued liabilities liabilities

Long-term debt Debt Financial

Assets capital Capital Structure
Stockholder’s equity Equity structure
Preferred stock capital
Common stock
Measures of capital structure

Debt to
Debt ratio equity
ratio

Times
EBITDA
interest
coverage
earned
ratio
ratio
Capital Structure Theories
1.  Modigliani and Miller (M&M) Irrelevance
Theory
2.  Trade-off theory
3.  Signaling theory
4.  Pecking order hypothesis
5.  Windows of opportunity
The Modigliani and Miller (M&M)
Irrelevance Theory

!  the capital structure that a firm chooses

does not affect its total market value
!  Value of the firm is determined by how
much cash the firms has to distribute and
how these are valued by financial markets

Firm Value = [EBIT (1-T)]/ WACC

Firm Value = stock price x CS outstanding
WACC under M&M Theory
M&M Theory Assumptions
M&M Assumption I: The cash flows that a firm generates
are not affected by how a firm is financed
M&M Theory Assumptions
No taxes

M&M Assumption II:

No flotation Symmetrical
or transaction
Financial markets information
costs are perfect

No Same
bankruptcy borrowing
cost rate
Trade-off Theory
!  States that firm trade off tax benefits of
debt financing against problems caused
by potential bankruptcy

MM

Tax-effect

Effect of tax
and
bankruptcy
WACC under Trade-off theory
 Trade-off Theory
!  Market frictions or factors affecting capital
structure
1.  Corporate taxes
2.  Personal taxes
3.  Cost of bankruptcy and financial distress
4.  Agency costs
›  Outside equity
›  Outside debt
 Trade-off Theory: Corporate Taxes
!  Debt financing provides tax savings
!  Interest expense are tax deductible, whereas
dividends are not
Trade-off Theory: Personal taxes
!  Equity financing provides personal tax
advantage
!  capital gains and dividends are taxed at lower
rates than interest income

10% on cash dividends

20% on
6/10 of 1% on stock selling price VS. interest
or 15% on capital gains income
Trade-off Theory: Bankruptcy Cost
!  Debt financing will increase possibility of the firm
to default on interest and principal payments
which could put the firm in financial distress and
eventually force them into bankruptcy
Bankruptcy Constrained capital Loss from
filing and
distressed
administration
fire-sale
Lost sales Higher supplier
prices
Employee
resignations Diversion of
management time
Other problems associated with financial
distress
!  Asset Substitution Problem
"  Managers will prefer high-risk investments since the result
of playing safe or unsuccessful project is the same
(default)
"  Shareholders have everything to gain and nothing to lose
!  Underinvestment Problem
"  Rejecting a profitable project that requires additional
financing from shareholders since payoffs would only
benefit bondholders

Cost of debt (and cost of equity) will increase as a

result of increasing expected costs of bankruptcy
 Trade-off Theory: Agency cost of
outside equity
Agency costs (outside equity)- costs incurred by a
firm’s common stockholders when firm’s management
makes decisions that are not in the shareholder’s best
interest but instead further the interests of the
management (e.g. pet projects or perk consumption)

•  Debt financing mitigate agency cost of outside

equity through its regular debt service
requirements by:
•  Reducing free cash flows
•  Forcing managers to be careful with
shareholder’s money to avoid losing their jobs
 Trade-off Theory: Agency cost of
outside debt
Agency costs (outside debt)- costs incurred by
bondholders when firm’s management, acting on
behalf of stockholders, takes advantage of lenders
such as investing in risky projects or incurring
additional debt
!  Equity financing reduces agency costs of
outside debt
!  Bondholders protect themselves with
positive and negative covenants in lending
contracts.
 Pro-debt Pro-equity
(levered) (unlevered)

Personal taxes

Corporate
taxes Bankruptcy
costs
Agency cost of
outside equity Agency cost of
outside debt
Signaling Theory
States that management’s actions provide clues
to investors about the firm’s prospects and
stock valuation
Debt financing is viewed as “positive signal” that firm
has favorable prospects and stock is underpriced;
while
Stock offering is viewed as a “negative signal” that
firm has unfavorable prospects and stock is
overpriced
Assumes asymmetric information, a situation in
which managers have more/better information
about firm’s prospects than do investors
 Pecking Order Hypothesis
States that managers will tend to adhere to a
hierarchy of financing as follows:
1.  Spontaneous credit (A/P and accruals)
2.  Retained earnings
3.  Marketable securities (short-term debt securities)
4.  Debt (bonds)
5.  Hybrid securities (e.g. convertible bonds)
6.  New common stock
"  new equity financing is undesirable because of
flotation cost (& underpricing) and signaling effects
due to asymmetric information
States that managers
adjust the firm’s capital
structure to take
advantage of mispricing

When stock is
overvalued, managers
issue new equity

When stock is
undervalued, managers
use debt or even
repurchase stock
Optimal or Ideal Capital Structure
!  Is the capital structure that maximizes
company’s value
!  Factors affecting capital structure decisions:

1. Sales stability 8. Management attitudes

2. Asset structure 9. Lender and rating
3. Operating leverage agency attitudes
4. Growth rate 10. Market condition
5. Profitability 11. Firm’s internal
6. Taxes condition
7. Control 12. Financial flexibility
Optimal or ideal capital structure
Approaches
1.  Lowest WACC
○  Hamada equation
2.  EBIT-EPS approach
3.  Stock price
maximization
Lowest WACC
Focuses on
minimizing
WACC in
order to
maximize firm
value

Value of the Firm= NOPAT/ WACC

NOPAT = EBIT x (1-T)
kwacc = [kd x (1-T) x wd] + (kps x wps) + (kcs x wcs)
Hamada equation
!  attempts to quantify the increased cost of
equity due to financial leverage (using beta
and CAPM)
βL = βU[1 + (1 – T)(D/E)]
r = rf+ β(rm – rf)
!  It assumes that increased use of debt
causes both the costs of debt and equity to
increase
CJA Inc. projects EBIT of P800,000 next year. The
firm's income tax rate is 30%. CJA presently has
P2 million capital with no preferred stock and no
debt; hence, its WACC is equal to its cost of
equity of 12%. The firm is considering the
following alternatives to finance its P1 million
project next year.
Bonds CS Bond’s
YTM
1 300K 700K 8%
2 600K 400K 10%
3 800K 200K 12%
4 1M 0 15%
Compute for levered beta, cost of equity, WACC and value
of the firm under each alternative if risk free rate is 7% and
market risk premium is 5%.
EBIT-EPS approach
EBIT-EPS (expected EBIT)
!  involves selecting the capital
structure that maximizes
EPS over the expected
(range of) EBIT
!  Assuming an expected EBIT,
plot EPS for different capital
structures
!  EPS starts to decline when
increase in interest is not
fully offset by reduction in
CS outstanding
EBIT-EPS Approach

•  First, compute for at least two EBIT-EPS

coordinates by assuming specific EBIT values
and calculating EPS associated with them

•  Then, plot the data in an EBIT-EPS chart (or

range of earnings chart) which is the graphical
representation of EBIT-EPS relationship
EBIT-EPS Approach
EBIT-EPS (expected range of EBIT)

also shows effect of financial leverage effect (more debt, steeper line)- use
of debt financing leads to greater impact on level and volatility of EPS
EBIT-EPS Approach (cont’d)
•  Financial breakeven point- level of EBIT for
which the EPS just equals zero (0)
•  Financial breakeven point = Int + [PD div/ (1-T)]

•  EBIT-EPS indifference point- level of EBIT that

produces the same level of EPS for two different
capital structures
EPS alternative1 = EPS alternative 2, where
Stock Price Maximization
!  Selecting the capital structure that maximizes firm’s
value as measured by stock price

!  First, estimate the level of return (rs) that it must earn to

compensate owners for the risk being incurred under
each alternative capital structure
1.  Using CAPM but estimating beta associated with each
alternative capital structure
2.  Link financial risk (coefficient of variation) associated with each
capital structure alternative directly to the required return
!  Then, compute for estimated stock price using zero-
growth model:
Maximizing EPS vs. maximizing share value
Stock Price Maximization
Overcomes major shortcoming of EBIT-EPS
approach as follows:
•  tends to concentrate to maximizing earnings
rather than shareholder’s wealth
•  fails to risk- assumes shareholders did not
require risk premiums (additional return) as
the firm increased its use of debt
OPTIMAL CAPITAL STRUCTURE
Bait Coin, Inc. is considering two capital structures shown below.
Source of capital Structure 1 Structure 2
LT debt P500,000 @ 10% P305,000 @ 8.5%
Common stock 100,000 shares 113,000 shares
D/E ratio 40% 16%

Assume a 30% tax rate, expected EBIT of P650,000, risk free rate of 5% and
market risk premium of 7%.

(a) Calculate the financial breakeven point of each structure,

(b) Indicate over what EBIT range, if any, each structure is preferred.
(c) Calculate the expected EPS under each structure. Which capital structure
should Bait choose?
(d) Calculate the estimated share values if unlevered beta is 1.25. Which capital
structure should Bait choose?
Optimal or ideal capital structure
Approaches
1.  Lowest WACC
○  Hamada equation
2.  EBIT-EPS approach
3.  Stock price maximization

•  it is impossible either to know or to remain at

the precise optimal capital structure;
•  firm’s normally works toward a target capital
structure
 Contents
3.1 Leverage and Capital structure 3.1.5 Optimal or Ideal Capital
3.1.1 Business and financial risk Structure
3.1.2 Types of leverage 3.1.5.1 Factors affecting
3.1.2.1 Operating leverage capital structure decisions
3.1.2.2 Financial leverage 3.1.5.2 WACC and capital
3.1.2.3 Total leverage structure
3.1.3 The Firms Capital Structure 3.1.5.3 Hamada equation
3.1.4 Capital Structure Theories 3.1.5.4 EBIT-EPS approach
3.1.4.1 Modigliani and Miller 3.1.5.5 Share value
(M&M) maximization
3.1.4.2 Trade-off theory
3.1.4.3 Signaling theory
3.1.4.4 Pecking order hypothesis
3.1.4.5 Windows of opportunity
 Exercise
Downtown Packages is financed entirely with 500,000 shares
of common stock with book value of P25 per share but
currently priced at P20 a share. Downtown’s current WACC is
14% using 6% risk-free rate and 10% market risk premium. The
firm pays 100% of its earnings as dividends. EBIT is expected to
be P2 million for the foreseeable future. Due to underpricing
of its stocks, the board of directors is deciding to retire either
P2 million or P4 million in common stock, replacing it with 7%
and 10% long-term debt, respectively. Assume 30% tax, zero
growth.

Under each capital structure, compute for expected DFL,

shares outstanding, beta/ cost of equity , and WACC (using
book value), value of the firm, EPS and estimated stock price
 Current (0 debt) P2M debt @ 7% P4M debt @ 10%

DFL

# shares

D/E

Beta

Cost of equity

Debt ratio

WACC

Firm value

EPS

Stock price